Captive Collateral (Part III) GAP Collateral

Greg Lang, founder of the Reinsurance and Insurance Network (RAIN), continues his series of articles on collateral.

The fourth quarter is always busy. Most reinsurance activity revolves around treaties and facultative renewals for January 1. I was busy for another reason. One client wanted to purchase stoploss. It had nothing to do with adverse loss development. Another wanted a better deal on excess. That’s fair. They have not had an excess claim in 20 years. Why renew? A third has been reinsuring 100% of their risk to a captive. They needed reinsurance to continue to grow. All are comfortable taking risks.

We could have a healthy debate if assuming 100% makes sense. They believe it does. Their need for reinsurance is driven by collateral. Fronting carriers require it. Each front required more collateral than the insureds believe reasonable or could reasonably post themselves. This is the third time a captive owner feels an invisible hand in their business. The situation each insured is trying to satisfy is a need for gap collateral.

The term gap collateral comes from banking: collateral to secure a gap loan or, Guaranteed Asset Protection (GAP) insurance to cover the gap between a vehicle’s value and the loan balance in the event of a total loss. In the first case, gap collateral might be cash or a letter of credit substituted for other collateral during a specific period of a commercial loan. In the second, collateral is the vehicle itself. GAP insurance protects against a financial shortfall that occurs when the insurance payout is less than the outstanding loan amount.

Gap collateral in insurance is similar. It provides protection for the gap between the premium paid and the aggregate limit of insurance purchased. If there is no aggregate on the policy, the gap is the difference between the premium and the worst-case scenario loss pick selected by the fronting company’s actuary. Gaps or shortfalls are created based on a concern for adverse loss development. This is especially true for long tail lines of insurance.

A captive feasibility study should provide an opinion of what your actuary believes the worst-case scenario could be. This is helpful when you receive a collateral request from your front and their actuary. Hopefully the numbers are close. If not, in the captive world we call this the battle of the actuaries. Unfortunately, your side brought a knife to a gunfight. The fronting carrier will ultimately decide what the numbers will be. Most differences are based on what each actuary believes is the worst-case scenario.

A worst-case scenario could be at a 90% confidence level, 95% or even 99%. A 90% confidence level has a 10% chance of being wrong; 95% is 5% and 99% has a 1% chance of being wrong. The percentage chosen depends on the insured’s risk profile and the ultimate decision-maker, which is not you. An insurer’s internal policies and procedures mandate a certain level of collateral to mitigate credit risk and meet statutory reserves. This is where your actuary’s numbers help, and the relationship and continuity between insured and insurer helps too. We will get more into this later.

Collateral stacking

Collateral stacking refers to the accumulation of collateral insurers required to cover gaps for multiple policy years. Stacking collateral is an ever-growing request as new policy years add to the existing obligations even as claims are paid. It’s a significant financial consideration. New collateral stacks on top of existing collateral posted in prior years. Collateral obligations impact on an insured’s cash flow until all claims are paid. Some refer to this as collateral jail. Having all your collateral tied up with one insurer makes it difficult to change insurers if you need or want to.

When an insurer first offers coverage, they require collateral to cover the gap between the premium paid, and their worst-case scenario. When a new policy year begins, new collateral is requested on top of the collateral already held for older policy years. This creates the stack. The total collateral held grows as each new policy is written. Collateral in older years can also increase if prior year loss develop worsens. Collateral only shrinks as claims are paid and closed.

Stacking collateral increases costs. This is part of my frustration with feasibility studies and the parties that push them. They often don’t explain this. I saw a recent estimate of $300 billion trapped in pledged collateral. I think the number is higher.

The nonprofit association AIRROC was created 21 years ago to help insurers and reinsurers deal with legacy claims. AIRROC used to be an acronym for Association of Insurance and Reinsurance Runoff Companies. Legacy claims generally refer to older unresolved claims that linger on a company’s balance sheet. Runoff refers to policies and claims from companies, including captives that are no longer in business. They have claims and therefore capital is tied up with insurers they no longer do business with. I know one fronting company that has more than 150 captives in runoff. Since captives have a 50% attrition rate, this is not surprising. If you are surprised by this attrition number, I explained where I derived it in a prior article in this publication called ‘Captives by the Numbers’.

So, if you have read this far including my two prior collateral articles, you have a better appreciation of why collateral is needed but also feel and see the burden it creates. You know it’s bad when before the first dollar of premium is paid, I’m often asked, when do I get my collateral back. Let’s look at some strategies you can deploy to better manage and reduce collateral.

Alternative Collateral

Reinsurance is the first-place insureds turn to reduce collateral. It is such a common solution, it is often overlooked as a collateral alternative. The clients I referenced earlier all wanted to access reinsurance to replace other forms of collateral. Excess and aggregate excess are the most common collateral replacement products.

Excess insurance and reinsurance protect against loss severity. Aggregate stop loss protects against the adverse development of frequency claims within a captive’s retention.  Both coverages are usually purchased for a single policy period. When purchasing reinsurance, the captive’s excess attachment point and the aggregate attachment point become fixed, resulting in a pre-determined or fixed collateral number.

Parental guarantees are another form of collateral. A parent promises to cover the debts of its subsidiary. If a captive fails, the parent acts as a safety net to make the insurance company whole. Parental guarantees are generally not treated as admitted assets for statutory accounting purposes. If you recall, admitted assets need to be easily convertible to cash. A parent’s promise is too uncertain to qualify as an admitted asset. Despite this, insurers are quick to accept them. The financial alignment they provide supersedes the accounting treatment. Unfortunately, a guarantee receives negative treatment for the parent. It is a liability on the balance sheet from a GAAP accounting perspective. They are therefore unpopular with CFOs. Guarantees negatively impact a company’s ability to borrow funds.

Surplus notes are another form of collateral. They present both regulatory and accounting challenges. Surplus notes require regulatory approval from your state of domicile. Secondly, the note must be subordinate to all policy holder and creditor claims. I know what you’re thinking, and you would be wrong. Surplus notes do qualify as statutory assets for captives. They also qualify as debt on that same captive’s balance sheet for GAAP accounting purposes. Yes, you read that right. They are both an asset and a liability on the same balance sheet depending on the accounting treatment. I will let your legal and tax expert explain that one. It makes little sense to me, too.

Claims handling is another collateral management strategy. Open claims are liabilities insurers must collateralise for. Early reporting of claims and closing claims quickly offers predictability of outcome. Predictability reduces the need for collateral. This is why building trust between parties helps. If the insured has a track record of consistency and predictability of reporting, reserving and closing claims, it helps the collateral discussion. Predictability can also reduce future premiums and might allow an insured to lower their retention cost effectively. If the insurance company has been responsible releasing excess capital, the insured feel less risk of collateral jail.

The type of claims you have also impacts collateral. It’s easy to understand why short tail claims would require less collateral than long-tail claims. It also makes sense that a claim’s made policy would require less collateral in the early years than an occurrence policy. Over time, a claim’s made policy will have a similar exposure as more policies renew and the retroactive date gets extended. My company’s E&O policy has a 15-year tail. The retroactive date goes back to 2011.

What if this policy had a claims-paid feature? We recently added one to a client’s claims made policy to save on collateral. Covered claims still need to be reported during the retroactive period but now claims also must be paid during that same period. Unpaid but reported claims will only be covered and paid if the policy renews. This claims-paid strategy helps remove the collateral stacking problem associated with prior year losses. It shifts the burden of future claim payment to current and subsequent policies. I will keep you posted on how we make out.

Traditional collateral

Most captives post collateral using a combination of cash and/or letters of credit. I am often asked if other options are available. We already covered some of the less traditional ones. Some common requests for assets to qualify as admitted assets include company receivables, bitcoin, real estate or other hard assets such as furniture, art, cars or boats. The quick answer is no. These assets are not liquid enough.

When pressed, I often refer to New York’s insurance trust statue that provides a list of acceptable collateral options. Two qualify, these assets must be held in trust by a trustee for the sole benefit of the insurance company, who can request withdrawals for covered obligations. The list of assets can be found under regulation 114. It’s where the term 114 trust comes from. Regardless of your domicile, most states use the same or similar asset lists.

A Regulation 114 Trust requires the holding of specific, high-quality, liquid assets, such as cash, certificates of deposit (CDs), government bonds, corporate bonds (rated A or better), and preferred or guaranteed stocks. Further guidance and restrictions on these assets can be found in NY insurance law § 1404(a) (specifically (1), (2), (3), (8), (10)).

Since it is January, some of you have already had your battle of the actuaries for the 2026 policy year. If you remember from last year, planning your collateral strategy three weeks before the money is due is not a strategy. The collateral discussion is an ongoing one and should be revisited often.

Happy New Year.

Greg Lang can be contacted at: glang@rainllc.com

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